Académique Documents
Professionnel Documents
Culture Documents
Alternative one is performed as a standard construction with plastic/linoleum floors in the whole apartment, the walls and floor surfaces in bathroom would be in plastic/linoleum. Alternative two is performed as an intermediate construction, in the living room we would have hardwood floors and for the kitchen and hallway we would use laminate floors, the bathroom would be upgraded with standard tiles. Alternative three would be performed with the highest standards on all floors in the apartment; bathroom and kitchen to be upgraded with the highest quality. The company that you work for has decided on an annual discount rate for each project, the discount rate for conversion of vacant premises is set to 6%. The question you need to ask yourself is, which alternative should you choose? Based on the things you already now it is possible to calculate the best alternative. On the following pages I will describe the best alternative for the company.
Alternative 1 ((550000/2750000)*6%)+(2200000/2750000)*(125%)*4%=3.60 % Alternative 2 ((600000/3000000)*6%)+(2400000/3000000)*(125%)*4%=3.60 % Alternative 3 ((700000/3500000)*6%)+(2800000/3500000)*(125%)*4%=3.60 % 3.60 percent is the minimum yield on the total assets which the company can tolerate in order to meet its lenders' interest rate requirements and its owner's distribution requirements for this project.
Alternative 1 Risk-free intrest rate (rf) Beta () Expected rate of return on the market portfolio (rm) 4% 0,5 8%
Alternative 2 4% 0,5 8%
Alternative 3 4% 0,5 8%
With a known beta of (0.5) for this project and the company, you can calculate the CAPM. 0.04 + 0.5(8%-4%) = 6% The minimum return that the company can tolerate is 3.6 percent and the expected return is 6 percent for the project. Now is the time to look at which alternative is most profitable for the company. The Net Present Value Alternative 1 -2750000+(227850/(6%-2%))-(227850/(6%2%))*(1+2%)20/(1+6%)20 = 307033 Alternative 2 -3000000+(249550/(6%-2%))-(249550/(6%2%))*(1+2%)20/(1+6%)20 = 348179 Alternative 3 -3500000+(271250/(6%-2%))-(271250/(6%2%))*(1+2%)20/(1+6%)20 = 139234 Apparently alternative two is the most profitable, which means that it is this alternative we will choose.
Initial Yield
Alternative 1; 227850 / 2750000 = 8.28% Alternative 2; 249550 / 3000000 = 8.31% Alternative 3; 271250 / 3500000 = 7.75%
Using this method we also come to the same conclusion as above, we will choose alternative two.
Summary
The company cost of capital is the cost of capital for investment in the company as a whole. It is usually calculated as a weighted-average cost of capital, that is the average rate of return demanded by investors in the companys debt and equity securities. You define risk as beta, and you use the capital asset pricing model to estimate expected returns on the project. The company cost of capital is the correct discount rate for projects that have the same risk as the companys existing business.
Group Work
Conversion of vacant premises to apartments
Alternative 1 Alternative 2 Alternative 3 Rent, sek/sqm/year Sqm Construction cost Life expectancy Yearly rental development= inflation Beta () Expected rate of return on the market portfolio (rm) Equity Debt Assets Rate of corporate income tax(tc) Expected rate of return on firms equity (re) Risk-free intrest rate (rf) 1050 217 2750000 20 2% 0,32 8% 1375000 1375000 2750000 25% 7% 5% 1150 217 3000000 20 2% 0,32 8% 1500000 1500000 3000000 25% 7% 5% 1250 217 3500000 20 2% 0,32 8% 1750000 1750000 3500000 25% 7% 5%
The company that you work for has decided on an annual discount rate for each project, the discount rate for conversion of vacant premises is set to 6%.
Questions
1 Calculate weighted average cost of capital WACC. 2 Calculate the expected return for the project, using the CAPM. 3 Calculate the NPV for this project. 4 Calculate the Initial Yield for this project. 5 Calculate the Internal Rate of Return for the project by using excel. Make the calculations using the information above to solve the questions. Which alternative should the company choose?